Regulation – When It Works

Often the debate over regulation is based on ideological extremes. We rarely bother to ask whether or not a regulation does what’s intended.  Even fans of regulation would have a hard time supporting a regulation if it doesn’t achieve the desired outcome.  While it would be impractical to list regulations one-by-one, we can certainly talk about the general features of a regulation (and of the problem) that affect whether or not a regulation is effective.

Even a faithful student of free-market economics must recognize that market failures exist in real markets.  A variety of phenomena like public goods, natural monopolies, and imperfect information (or information asymmetry) can drag markets away from perfect efficiency.  While regulations may not be appropriate for every circumstances, they certainly provide an alternative for reducing inefficiency in these markets.

If efficient markets are not your primary goal, regulations are a particularly attractive way of distorting markets towards other (typically social) aims like distributive equity.  While this case is an important motivation for crafting a variety of regulations, the diversity of goals make it difficult to discuss categorically.  Instead, let us consider only the case where regulation is put in place to address a perceived inefficiency in the market.

Regulatory Capture

The most obvious and least interesting of the weaknesses of regulation is known as regulatory capture.  In this theory, businesses (or other regulated entities) are able to influence regulation through special interests and other tactics.  This influence causes the regulations to implicitly favor the interests of the regulated entity over the interests of the public (presumed to be the beneficiaries of the regulation).  A common example is the protection of entrenched competitors against new entrants, as is a common complaint of certification organizations.  A variety of examples are provided on Wikipedia.

Even though “captured agencies” are working against the public interest, effective regulations are generally bad for society.  However, the effectiveness of these regulations depend on the same basic principles.

Principles of Effectiveness (in progress)

In general, a regulation requires a series of successful outcomes:

  1. Detection of a violation
  2. Reporting of a violation
  3. Procedures determining the application of penalties
  4. Enforcement of penalties
  5. Effectiveness of penalties

A failure to regulate can arise at any of these steps.  In addition, a regulation can be so costly to enforce that (or of such minimal benefit to society) that even an effective regulation can represent a reduction in public welfare.

… more coming soon

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